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2.1 Pension Wealth Accruals

The simulation model essentially involves calculating the present value of the changes in expected pension wealth accruals associated with each year of employment for representative employees at different ages. This is expressed as a percentage of the employee’s wage or annual earnings in each year. To be consistent with Gruber, the wage is assumed to be constant throughout the working life. Pension wealth in a given year is the discounted present value of the stream of pension payments ⁶ to which the employee would be entitled if the employee retired and left the plan at the end of that year. The change in pension wealth, or pension benefit accrual in that year, is the change in that wealth if the employee remains in the plan for that year. An annual pension wealth accrual of 20% of an employee’s wage at age 59, for example, would mean that if the employee worked and remained in the plan until the age of 60, the increased value of their pension wealth would be the equivalent of 20% of their wage for that year. If their annual earnings for that year, for example, were $50,000 then their pension wealth increases by $10,000 if they work that year and retire at the end of the year. In effect, their total compensation including the change in their pension wealth would be $60,000 ($50,000 from wages and $10,000 from increases to their pension wealth).

Clearly, such changes in pension wealth can have important incentive effects on the retirement decision — augmenting those that exist from wages themselves. This is especially the case when, as illustrated below, large "spikes" or discontinuities in year-over- year pension wealth accruals are associated with institutional features of such plans, including early and special retirement.

2.2 Three Representative Types of Plans

To illustrate the financial incentives or disincentives embodied in such private plans, three representative types of final-earnings defined-benefit plans are considered. Each embodies specific plan features so that successive comparisons of the pension wealth accruals associated with each type of plan can illustrate the different financial incentives they embody. While the pension plan features are representative, they do not necessarily exist in all pension plans. The representative plans and their key features (highlighted in italics) are as follows: the Basic Plan; subsidised early retirement; and early and special retirement. These are described in the next few pages.

Basic Plan: In this defined-benefit plan RPP, ⁷ the normal retirement pension benefit formula is 2% of final (three-year) average earnings for each year of service up to a maximum of 35 years of service. The pension payment commences at the normal retirement age of 65. For example, if the employee had 35 years of service and they retired at the age of 65, their employer pension would be 70% of their final, three-year average earnings. Additionally:

• Reflecting the recent legislative requirements in Canada, the plan vests after two years of service; that is, the person has a right to both their own contribution and that of their employer after two years of service.

• The plan is integrated with CPP/QPP in that there is an offset or reduction in employer pensions associated with the receipt of CPP/QPP. That offset in this plan is 0.6% of earnings up to the Year’s Maximum Pensionable Earnings (YMPE) as established by CPP; that is, the benefit formula is 1.4% of earnings up to YMPE and 2% on earnings in excess of YMPE. This integration occurs at age 65, upon receipt of normal CPP/QPP (its being offset by a possible bridging supplement and the age of early retirement is discussed below).

• Unsubsidised early retirement is available at age 55 or beyond, with at least 10 years of service; that is, there is an actuarially fair reduction of benefits designed to reduce the annual benefits to exactly compensate for the fact that they are received sooner and for a longer period of time.

• The Basic Plan does not have subsidised early retirement or special retirement (both discussed below).

• As with all other plans, the benefit accruals under the Basic Plan are calculated with and without bridging supplements. Bridging supplements effectively waive the integration offset for persons who take early retirement (as early as 55) in advance of receiving CPP/QPP at age 65. In the simulations developed in this report, this means that if the employee retires under an early or special retirement feature, the benefit is calculated as a flat 2% of final earnings until the age of 65, thereby compensating for the typical offset of 0.6% as discussed above, on earnings up to YMPE. Thereafter, when the employee is in receipt of regular CPP/QPP at age 65, the integration offset applies. In effect, the bridging supplement is a bonus to early retirement since it applies at the age of early retirement and is designed to bridge the gap in income that otherwise would prevail if the employee retired early and did not receive CPP/QPP until age 65.

• With respect to postponed retirement, if the employee works beyond the age of 65, they can no longer accrue additional pension credits, but the pension that is normally payable at age 65 is actuarially increased at the time the employee does retire and commences to receive their delayed pension. The actuarial adjustment is fair in that it is designed to exactly compensate for the fact that the pension is received later and for a shorter expected period of time.

Subsidised Early Retirement: The subsidised early retirement plan is the same as the Basic Plan except that the early retirement benefit that is available at the age of 55 and with at least 10 years of service is reduced by 5% per year for each year of age that early retirement precedes normal retirement at 65. This involves a subsidy because the benefit reduction is less than the actuarially fair reduction that would reduce the annual benefits to exactly compensate for the fact that they are received sooner and for a longer period of time.

Subsidised Early and Special Retirement: The subsidised early and special retirement plan is the same as the subsidised early retirement plan except that a special retirement feature is also available when the employee attains the age of 60 with at least 20 years of service. Special retirement essentially involves a larger subsidy in that there is no reduction in annual benefits (i.e., the reduction formula is zero) to compensate for the fact that they are received earlier (at age 60) and for a longer period of time.

2.3 Format of Results

For each of the three plan types, we show the pension benefit accruals expressed as a percentage of annual wages, separately for when a bridging supplement is provided (the integration offset waived if the employee retires between the ages of 55 to 65) and when a bridging supplement is not provided (the integration feature applies).

As indicated previously, the bridging supplement applies at the age of early or special retirement and continues until the receipt of normal CPP/QPP at age 65. The calculations are provided for each age between 55 and 69 since these are the ages that encompass the main institutional features such as early, special, normal and postponed retirement as well as the integration features and bridging supplements.

For each of these six calculations (three defined-benefit plan types with and without bridging supplements), the public pension benefits are then integrated to estimate total private and public pension wealth accruals. As discussed previously, the public plans, labelled SS ⁸ benefits, include the employment-based CPP/QPP, the universal OAS system, and the means-tested GIS and SPA.

The private pension benefits are combined with the public benefit accruals. The assumptions used with respect to key factors include a real discount rate of 3% ⁹ and a "base case" scenario, which is a median-wage ¹⁰ male born in 1930 and who commenced working in the organization at the age of 30, and whose wife was three years younger and who never worked. The employee is assumed to have worked continuously at the median wage. By the age of 65 he would have worked 35 years. Life expectancy estimates are based on Statistics Canada Life Tables, No. 84-537, 1995.

This analysis yields 12 sets of calculations of pension benefit wealth accruals (three defined-benefit plan types, with and without bridging supplements, and private pension accruals as well as private and public accruals). These 12 sets of calculations are illustrated in Table A (see end of report) for the base-case scenario, which assumes employees earn the median wage. The calculations are then repeated, respectively in Tables B to D, for employees whose wages are at the extreme bottom 10th percentile (as used by Gruber)¹¹ and at 1.5 and 2.0 times the base-case median wage.

The juxtaposition of each set of calculations highlights how the pension wealth accruals, and hence the financial incentives on retirement, are affected separately by each of the changes (e.g., subsidised early retirement, special retirement, bridging supplements, public pensions) for persons of different wage levels. The age of 65 corresponds to the year 1995 in these tables and the figures that follow.

The pension wealth accruals associated with the private employer-sponsored plans are first discussed so as to highlight the effect of the different institutional features of those plans. Then the impact of combining these pension wealth accruals with those of the public pension plans are presented and discussed.

Financial Incentives Created by Pension Wealth Accruals: The extent to which pension wealth accruals create an incentive to retire or to continue working is not only determined by the accruals themselves, assuming they are known by the worker. The retirement decision also depends upon the disutility of continued employment or the reservation wage associated with continued employment. That disutility likely increases with age, especially if health deteriorates, work becomes more onerous, one’s spouse retires, and one accumulates more assets.¹² As such, large and increasing pension wealth accruals may be necessary to provide the financial incentives to continue working and offset the increased disutility of work, especially if wage growth also declines with older age.

In such circumstances, pension wealth accruals may not induce retirement in any of the following circumstances: they are small; they are constant with age and hence do not offset any increased disutility of work; they decline with age; they decline immediately after a large positive spike; and, certainly, if they become negative and hence a penalty on continued employment. These various dimensions should be kept in mind when interpreting the financial incentives to retire that are created by pension plans. These dimensions will be illustrated in the examples that follow.

A Caveat

While the analysis applies to a necessarily simplified set of base cases and not necessarily typical of many workers, it is nevertheless illustrative of such potential effects. In particular, the assumption is made of a continuous work history at the median wage with no interruptions, of a male, with a spouse who never worked.¹³ In respect of private pensions, the focus is on workers who have defined-benefit RPPs of varying types (less than half the workforce).

Footnotes

6	The pension benefits are assumed to last for the worker’s remaining life expectancy, as given in Statistics Canada, Life Tables, Canada and Provinces, No. 84-537, 1995.
7	A defined-benefit RPP is one where the benefit formula is specified in advance. It is to be contrasted with the defined-contribution type of RPP where only the contribution formula is defined and benefits are determined by their investment return.
8	They are characterized as social security benefits in Gruber (1997).
9	This is the rate of return that would correspond to the real return on long-term (30 years) risk-free investment assets such as Government of Canada bonds. This rate was also used in the Gruber study.
10	This is the median wage as used by Gruber and is similar to the average wage. Specifically, the median annual earnings in 1995 was $37,022 for males based on the Survey of Consumer Finances (Statistics Canada, Earnings of Men and Women, No. 13-217 XPB, 1995). This exceeded the year’s maximum pensionable earnings under CPP/QPP of $34,236 in 1995. The average annual earnings in 1995 was $40,610 for males based on the same survey.
11	The bottom 10th percentile is used to demonstrate the effect of extreme dependency of the household on the means-tested GIS and SPA benefits.
12	See, for example, Anderson and Burkhauser (1985), Anderson, Clark and Johnson (1980), Bazzoli (1985), Breslaw and Stelcner (1987), Hausman and Wise (1985), Moffitt (1987), Sammartino (1987), and Wolfe (1985).
13	The base case worker has not availed himself of the CPP general drop-out privilege for low earnings years or non-employed years. ( a maximum of 15% of working years between the ages of 18 and 65 after 1966 when the CPP came into effect). Such workers only represented 10 to 16% of workers born in 1930.